Going back to basics: Supply & Demand

Every day investors come up with new strategies to try to “beat” the market.  Each year it seems these strategies become more and more complex and esoteric.  This quarter we began to incorporate new research into our regular investment committee meetings.  What drew us to this research was the simplicity of the idea behind the research.

In an investment landscape colored by hedge funds, central banks and high frequency trading, its easy to forget about the basics.  The notion of the research we recently added to our repertoire is grounded in the simple economics of supply and demand.

The hypothesis is that stock market prices are determined in the same way that the price of any good is set in an open marketplace.   As the number of shares available in the stock market changes (i.e. shift in the supply curve), the price of stocks in general must also change.  As liquidity for key market participants change (i.e. shift in the demand curve), the price of stocks in general must also change.

Before we go on to describe this strategy any further it might be helpful to review day one of high school economics class. If you have ever studied economics, even at a cursory level, you will probably be familiar with the following supply and demand graph.

supply_demand

The graph implies that as supply of any good decreases and demand is held constant, the price of the good will increase.  In the graph the Price moves from P0 to P1 when the Supply curve shifts from Supply to Supply(New).  The opposite would be true if the supply increased.  The Demand curve to the left can also shift right or left resulting in changes in price depending on the direction of the shift.

Back to the research; the number of shares available in stock market is called the “float.”  A decrease in the “float” creates an upward pressure on prices as the supply curve shifts to the left just as it does in the graph above.   An increase in the “float” puts a downward pressure on prices as the Supply curve shifts to the right.

Here are some of the common activities that will decrease the “float” of shares in the markets.

1. Stock buybacks occur when a company elects to use either cash from earnings or from issuing debt to buy back the company’s stock from the open market.   Those shares that are bought back are removed from the overall float of the market.

2. Cash takeovers are another way the “float” can be decreased.  In a cash takeover the acquiring company borrows or uses cash to buy the shares of the company its acquiring from the marketplace.   Those shares that are bought reduce the “float.”

Here are some common activities that will increase the “float” of shares in the markets.

1. New equity offerings such as an IPO introduce new shares to the market.  New offerings can also come from existing publicly trading companies who wish to raise capital through equity offerings.   Secondary offerings were one of the ways many financial firms tried to recapitalize their balance sheets during the financial crisis and their “float” increased.

 2. Insider selling can also introduce new shares into the market.  Many publicly traded companies will use stock options and restricted stock to compensate executives and other company insiders.  When those insiders exercise their stock options or sell previously restricted stock, new shares may be created and added to the “float” of the company, which increases the float of the entire market.

While Supply as measured by the “Float” is fairly straight-forward, estimating Demand is not quite as simple.  We do know that liquidity influences demand, so the research we have begun examining tries to predict demand by measuring sources of cash coming into or leaving the market.

 Here are a few examples:

1. Daily mutual fund flows track the amount of money coming into or leaving equity mutual funds.

2. Exchange Traded Funds(ETFs)  have become a major investment vehicle in recent years. Daily ETF flows can be tracked for all US based ETFs.

3. Hedge Fund investments and redemptions.   One survey compiles the monthly reported investment and redemption data of over 3,500 hedge funds.

4. Investor sentiment indicators are another source that can be utilized to help analyze Demand.  There are numerous sentiment indicators this research utilizes, but we will not go into all of those in this summary.

Application

We believe in a global, value-oriented and thoughtful long-term approach to investing.  Our hope is also to try to help clients avoid some of the volatility of falling markets by raising cash during certain periods of the market cycle. We are always in search of better tools to inform our decisions about when to make such moves.  There is no full-proof market-timing tool, nor does this research claim to deliver such precise information.  In fact, this research makes no short-term predictability claims.  It is a tool to help position portfolios over multiple quarters or years as large changes in Supply and Demand in the equity markets become evident.

 Something to think about

Share buybacks are one of the factors we listed for reducing the “Float” or supply of shares on the market.  Below is an interesting chart on stock buybacks going back to 2005.  The Left axis measures the quarterly dollar volume (in billions) of repurchases.  The right axis measures the number of companies repurchasing their own shares.

share_buybacks

 

Share buybacks have ramped up significantly in the past couple of years as the S&P 500 has continued upward.  Its hard to measure the exact influence of this factor alone, but all things being equal Share buybacks have clearly shifted the supply curve left and put pressure on market prices to go up.  Its simple economics 101.

 

 

 

 

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